Handout #10

Agricultural Economics 489/689Topic #10

Spring Semester 2008John B. Penson, Jr.

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Key Elements of FCA Examination Manual

This handout presents the key elements of the Farm Credit Administration’s Examination Manual followed by

A. Examination Objectives1. Determine the reliability and effectiveness of the institution's internal controls

relating to loan portfolio management.2. Determine the effectiveness and adequacy of the institution's loan portfolio

management.3. Determine the effect or potential effect of the institution's loan portfolio

management on the quality, composition, and profitability of the portfolio.4. Compare the institution's loan portfolio management practices to its risk-bearing

ability.5. Determine the scope and depth of testing needed to validate implementation and

effectiveness of loan portfolio management systems, processes, and internal controls.

Analysis of Internal and External Factors--This analysis should specifically consider factors that may impact the institution's loan portfolio. An analysis is completed to identify risks in the loan portfolio, threats to the loan portfolio, and opportunities that the institution may want to consider for enhanced profitability or growth. Once identified, the analysis should also determine the impact of those factors on the loan portfolio so that appropriate goals, objectives, and strategies can be established.

The adequacy of the institution's review and analysis of internal and external factors is largely dependent on the quality of the management information system (MIS). Extensive information from various sources is required to properly assess the institution's internal and external operating environment. While the board of directors may have access to reliable information on factors internal to the organization, the institution must also have access to complete and accurate information on external factors. The capability to predict the impact of external factors through stress testing (or similar means) further strengthens the institution's ability to operate in a safe and sound manner and to make timely adjustments to underwriting standards. The impact of such external factors as volatile commodity prices, global economic conditions, the agricultural credit market, pricing practices and services of competitors, interest rates, farm programs, existing and proposed regulations, technology, climatic conditions, and commodity markets should be analyzed. The institution's ability to adequately use this information in conducting sensitivity analyses will be dependent on the capabilities of the MIS. The key to evaluating an institution's analysis of internal and external factors is determining whether all relevant factors are considered and analyzed, and underlying assumptions are reasonable. Major assumptions made by the institution regarding commodity prices, credit quality, market share, competition, and loan growth should be well supported.

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Goals, Objectives, and Strategies--Once the institution's analysis of its operating environment is complete, goals and objectives for the loan portfolio should be established. The board of directors should also establish strategies that are designed to accomplish their loan portfolio goals and objectives and to proactively position the loan portfolio to manage threats and maximize opportunities.

Typically, goals, objectives, and strategies should be established for the loan portfolio to address the following areas:

Quality--Goals and objectives should be directed at the desired level of credit risk in the portfolio. This level of risk should be determined through the institution's review of internal and external factors, with particular emphasis on the institution's capital adequacy, profitability, and overall risk-bearing capacity. Strategies that can be employed to achieve goals and objectives in this area include:

Modifying loan underwriting standards to allow more or less risk or to require compensating strengths when certain credit factor weaknesses exist;Establishing credit administration standards, i.e., use of loan servicing plans and loan covenants;Modifying terms of credit extended, such as loan amortization requirements;Adjusting interest rates based on loan characteristics; andModifying capital and risk funds positions.

Loan Underwriting Standards--An institution's credit policy establishes a framework for lending and reflects an institution's credit culture and ethical business standards. The credit policy establishes a clear set of underwriting (lending) standards for the varied loan products under which funds are advanced. Credit policy should delineate the difference between underwriting standards and guidelines. Underwriting standards represent criteria, which require approval from supervisory authorities within the institution as delegated by the board or management. Exceptions to standards must be supported by compensating strengths in credit factors and/or approval controls above delegated levels.

Board-approved underwriting standards are indispensable to the safe and sound capital planning and portfolio administration in all FCIs. Loan underwriting standards delineate the desired or minimum level of creditworthiness for individual loans and the risk margin acceptable to the board of directors. They similarly ensure that loans originated comply with laws and FCA regulations. By specifying credit worthiness through standards, capital is insulated from unsafe and unsound lending practices or conditions. Therefore, in relation to loan underwriting standards, FCA defines unsafe and unsound conditions as any action(s) or lack of action that is contrary to generally accepted standards of prudent operations, the possible consequences of which, when continued, would expose an FCI or its shareholders to excessive risk or loss.

Underwriting standards clearly define, in measurable terms, the desired credit criteria for

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granting loans of acceptable risk. Acceptable loans should be categorized under three key evaluative areas (1) creditworthiness, (2) documentation and file completeness, and (3) legal and policy compliance. The appropriate evaluation of these three areas before loans are booked will reduce more loan losses than the best loan workout skills after cash is advanced. Therefore, underwriting standards should include:

The assessment of the loan's purpose and associated repayment program (primary and secondary); The evaluation of the five Cs of credit--character, capacity, capital, conditions, and collateral; The evaluation of loan legality; The determination of the economic benefits to the institution; Assurance that speculation is prohibited; and Assurance that loans originated are within the institutions area of expertise.

Once these components are assessed, individual institutions may weight the scoring of the components in accordance with their perceptions of importance, such as evidenced in the Contractual Interbank Performance Agreement (CIPA). However, the desired outcome of whatever process is chosen would be to report clear and quantified delineations of which individual loans do not meet or comply with acceptable loan standards as defined by the board of directors. The board (or its designated committee) should be provided periodic reports detailing which loans are not in compliance with acceptable standards. Additional queries by commodity, risk class, price, size branch location, etc. could be extracted to further delineate a pattern or practice, and corrective actions could be implemented, if necessary.

Underwriting standards communicate and implement the capital, credit, and operating culture of the board as it pertains to the origination and monitoring of individual loans. When appropriately implemented and monitored, they represent a key preventive control over the inherent risk in agricultural lending.

B. Risk Identification

Properly identifying risk in the loan portfolio is critical to the overall effectiveness of loan portfolio management. Because an institution's plans, direction, and controls are based upon a perceived level of risk in the loan portfolio, the ability to identify risk affects the adequacy of these areas. For instance, the board of directors may establish profitability objectives for the loan portfolio, which provide inadequate returns to shareholders or fail to offset future loan losses due to inaccurate assessment of risk in the loan portfolio. Also, adequate controls may not be implemented to prevent loans from deteriorating and resulting in loan losses.

A breakdown in the risk identification process could seriously threaten the safety and soundness of an institution. Weaknesses in risk identification not only hinder sound loan portfolio management, but also affect the institution's ability to determine allowance for

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loan losses requirements and capital, earnings, and liquidity needs. Risk must also be adequately identified to fairly and accurately disclose the financial condition of System institutions to shareholders and investors.

The primary risks emanating from the loan portfolio are credit risk and interest rate risk. Credit risk is the potential for losses resulting from the failure of borrowers to repay their loans, and interest rate risk is the potential for losses resulting from the impact of market interest rate fluctuations. The identification of credit risk is the focus of this discussion, while interest rate risk is further discussed in the Asset/Liability Management section of the Finance module. However, interest rate risk is mentioned here to highlight the need to consider it in evaluating loan portfolio management. Also, interest rate risk can result in significant credit risk in situations where interest rate risk has been passed on to borrowers through variable rate loans.

The examination of an institution's risk identification process should primarily focus on management's ability to identify aggregate risks in the loan portfolio. Aggregate risks that should be identified include: Criticized and adversely classified assets; Past due loans; Nonaccrual loans; Restructured loans; Other property owned; Concentrations of credit; Dependence upon a single or a few customers; Loans that do not comply with underwriting criteria; Lack of borrowers' current and complete financial data; Other credit administration deficiencies; and Loans with common credit factor weaknesses.

C. Examination Procedures

The examination of loan portfolio management begins with the assessment of the systems, processes, and internal controls discussed above. In many instances, this assessment is made on an ongoing basis through monitoring activities. Such activities typically include the review and evaluation of the business plan, changes in policies and procedures, internal audit and credit review reports, allowance for loan losses studies, and loan committee and board of directors meeting minutes and reports.

Although preliminary conclusions regarding the adequacy of loan portfolio management can be reached through this review, testing and verification are needed to determine that systems, processes, and controls are adequately implemented, working as designed, and effective. Testing and verification are particularly important when changes in the institution's performance, lending personnel, or lending philosophy occur; after a merger or new lending authorities are granted; or when there is a significant change in the economic environment affecting the institution.

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The examination of loans is the primary method used to test and verify the implementation and effectiveness of the various systems and processes that comprise loan portfolio management. Additional guidance on selecting and examining individual loans for this purpose is provided in the Asset Classifications, Accounting for Problem Assets, and Credit Administration sections of this module.

The following list of procedures is provided to assist examiners in the evaluation of loan portfolio management. Consistent with risk-based examination principles, examiners should add, delete, or modify procedures as needed based on the particular circumstances of the institution.

Examiners should also coordinate their examination activities with other members of the examination team and the examiner-in-charge (EIC). Emphasis should be on identifying how examination findings in other areas impact the review, ensuring sufficient work is completed to support conclusions and avoiding duplication of examination effort.

Strategic Planning:

1. Review the institution's mission statement and determine if it adequately defines the board's credit philosophy (i.e., type of credit provider and profitability of lending operations).

2. Determine if the institution's planning process adequately addresses the internal factors affecting the loan portfolio by determining whether the following areas were considered: a. Mission statement and credit philosophy; b. Underwriting standards and lending practices c. Capital and risk funds constraints; d. Amount of portfolio risk; e. Loan portfolio characteristics (credit factor weaknesses, enterprise/commodity, loan size/ type, and geographic locations); f. Capability of directorate, management, and staff; g. Internal controls, systems, and processes; and h. Asset/liability management.

3. Determine if the institution's planning process adequately addresses the external factors affecting the loan portfolio by determining whether the following areas were considered (as applicable): a. Types of commodities, enterprises, potential borrowers, and agricultural activities in the trade area; b. Economic profitability of existing and potential markets; c. Current and anticipated market interest rates; d. World market conditions; e. Farm program changes and subsidies; f. Public policy influences; g. Sources and cost of capital for the institution;

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h. Pricing practices and services of competitors; i. Urban and society influences; j. Environmental concerns; k. Weather conditions; l. Real estate and other collateral values; m. Off-farm income and unemployment impact; and n. Government regulations.

4. Review the assumptions made regarding the institution's internal and external operating environment for reasonableness by determining if assumptions are well supported with accurate, reliable, and complete information.

5. Determine if the institution subjects its assumptions to sensitivity analysis or modeling to determine the impact of such assumptions on the loan portfolio.

6. Determine if goals, objectives, and strategies were established in the plan and determine if they are: a. Quantifiable; b. Consistent with assumptions and analyses; and c. Reasonable and achievable.

7. Determine if the plan establishes goals, objectives, and strategies to address all key areas of lending operations, including: a. Quality of the loan portfolio; b. Composition of the loan portfolio; c. Profitability of the loan portfolio; and d. Growth and market share.

Lending Policies and Procedures:

1. Determine if lending policies and procedures have been established for each lending program authorized by the board of directors.

2. Review the lending policies adopted by the board for adequacy. (Refer to the Policies and Procedures section of the Management module).

3. Evaluate the adequacy of lending policies in conveying risk parameters to management by noting if the following (or other) parameters exist: a. Adverse assets to capital/risk funds and/or net income; b. Criticized assets to capital/risk funds and/or net income; c. Unsecured loans to capital/risk funds and/or net income; d. Collateral risk to capital/risk funds and/or net income; e. Concentrations of industry or commodity risk to capital/risk funds and/or net income; f. Lending limits to individual borrowers as a percent of capital/risk funds, i.e., in-

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house lending limits.

4. Review lending policies and procedures and identify all lending standards to determine: a. If the loan underwriting standards have been approved by the board; b. If standards exist for all authorized loan programs and major commodities financed, and whether they are industry specific or just generic standards; and c. The board's objective(s) for each standard and whether it is consistent with the strategic objectives and risk parameters for the portfolio or portfolio segment; and d. How each standard was derived and if it is adequately supported by studies, analyses, or reports on the financial performance or credit profiles for successful producers in that industry or commodity.

5. Determine whether, at a minimum, the loan underwriting standards address each credit factor, such as: · Repayment capacity margins; · Solvency and liquidity positions; · Loan maturities and other terms; · Loan-to-collateral-value ratios; · Borrower delinquency or bankruptcy status; and · Compliance with legal requirements and FCI lending policies

6. Evaluate the adequacy of underwriting standards by determining if the following criteria are met: · Commensurate with the risk-bearing capacity of the institution; · Considers the types, terms, and conditions under which loans will be made; · Establishes the desirable characteristics of credit factors under which the board expects lending officials to administer; · Establishes standards to measure and manage concentrations of risk by commodity/industry, loan size, and risk categories; and · Ensures compliance with applicable laws, regulations, and policies.

7. Determine if the board of directors is effectively using loan underwriting standards to achieve loan portfolio objectives and manage risk exposure within the FCI's risk-bearing capacity. How effectively do the standards: · Control overall loan portfolio quality and credit risk exposure in accordance with strategic business, capital, and loan portfolio plans? · Maintain or control loan volume and quality to ensure acceptable concentrations of risk within the portfolio? · Expand or restrict portfolio growth in accordance with business needs or changing conditions, such as threats or opportunities in financed industries or commodities? · Maximize loan portfolio profitability through close correlation of loan pricing and fees to loan quality and servicing needs as measured by loan underwriting standards? · Strengthen the quality of criticized or deteriorating loans? Are loan underwriting standards incorporated in loan servicing plans, agreements and/or closing letters to

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establish goals or objectives for borrower performance?

8. Determine if the board has implemented a process for effectively reviewing and revising underwriting standards on a periodic bases and whether this process ensures they are timely adjusted in response to changes in industry or market conditions.

9. Examine a sample of loans to determine if loan underwriting standards are enforced to control the institution's exposure to risk in the loan portfolio.

10. Review board meeting minutes and changes in lending policies to determine if the board adjusts loan underwriting standards as needed to control the institution's exposure to risk in the loan portfolio.

11. Review lending policies to determine if the board establishes adequate credit administration standards that address: a. Credit and financial information; b. Credit analysis and decisions; c. Monitoring and control; and d. Collection actions.

12. Examine a sample of loans to determine if credit administration standards are adhered to (For additional procedures, refer to the Credit Administration section of this module).

13. Review lending policies to determine if the board established adequate direction to ensure sound lending practices and compliance with FCA Regulations. Consider areas such as: a. Conducting collateral evaluations; b. Lending limits to individual borrowers; c. Loan purchases and sales; d. Loan terms and conditions; and e. Lending authorities.

14. Examine appropriate samples of loans to test adherence to the policy direction referenced in procedure 17 and compliance with FCA Regulations. (Use FCA 3010 and 3011 to test compliance with lending limit regulations.)

15. Review board meeting minutes and lending policies and procedures to determine if they have been reviewed at least annually and updated as needed.

Risk Identification:

1. Determine if the institution adequately identifies the aggregate risks in the loan portfolio by noting if the following, and other areas of risk, are identified and reported to the board of directors: a. Criticized and adversely classified assets and the basis of criticism; b. Past due loans;

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c. Nonaccrual loans; d. Restructured loans; e. Other property owned; f. Concentrations of credit; g. Collateral risk; h. Dependence upon a single or a few borrowers; i. Exceptions to underwriting standards; j. Lack of borrowers' current and complete financial data; k. Other credit administration deficiencies; and l. Loans that do not comply with policies, procedures, and regulations.

2. Review management's analyses of the loan portfolio to determine if they include an evaluation of how external factors may affect the level of risk in the portfolio (e.g., projecting the change in asset quality given a certain percentage decline in commodity prices or collateral values, or an increase in interest rates).

3. Review board meeting minutes and reports to determine if information regarding risk in the loan portfolio is complete, timely, and meaningful.

4. Based on the above procedures, conclude on the adequacy of the MIS in identifying and reporting risk in the loan portfolio.

5. Review the board's policies regarding the use of the Uniform Classification System or other risk rating system to determine if sufficient direction is provided to ensure reliable, accurate, and consistent reporting of risk in the loan portfolio.

6. Review the board's policies regarding accounting for problem assets for consistency and compliance with generally accepted accounting principles and FCA Regulations.

7. Examine a sample of loans to determine if risk is accurately identified and reported (Refer to the Asset Classifications and Accounting for Problem Assets sections of this module for additional procedures).

Internal Credit Review Process:

1. Determine if the board established policies to direct the operation of a program to review and assess its assets [FCA Regulation 12 CFR § 618.8430(c)].

2. Review the policy established to direct the operation of a program to review and assess assets to determine if it includes standards that address the following areas: a. Loan, loan-related assets, and appraisal reviews; b. Scope of review selection; c. Workpapers and supporting documentation; d. Asset quality classifications; e. Assessing credit administration; and f. Training required to initiate the program.

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3. Through discussions with the board or its audit committee and a review of pertinent personnel files, evaluate the competency of the ICR personnel by considering: a. Level of education; b. Significant experience; c. Availability and participation in continuing education programs; d. Membership in professional organizations; e. Training methods; and f. Level and quality of supervision.

4. Through discussion with appropriate personnel and the use of flowcharts, observation, and/or investigation, analyze the operation of the overall ICR process by considering: a. Method of loan selection; b. Frequency and scope of reviews; c. Manner in which loans are analyzed; d. Criteria for upgrading criticized assets; e. Reports generated and provided to the board; f. Use of results by appropriate personnel, (i.e., follow-up and corrective actions); g. Any possible restrictions placed on the review function personnel; h. Whether the review function reports directly to the board; i. Independence and objectivity of the review function; j. Assessments of the institution's adherence to regulations, credit policies, procedures, and underwriting standards; k. Identification of credit administration weaknesses; l. Accurate and timely asset and performance category classifications; m. Identification of causes of any deficiencies and adverse trends; n. Assessment and status of corrective action plans; and o. Input for credit reports and the quarterly allowance for loan losses study.

5. Examine a sample of loans reviewed by the ICR process and compare examination findings to those identified by the review function.

6. Conclude on the adequacy of the ICR process using the criteria discussed under the ICR heading of this section.

Other Internal Control Systems:

1. Identify all standard and customized reports the institution develops that utilize or present data related to loan underwriting standards. Determine whether the system provides periodic reports that: a. Show each loan's compliance with the approved underwriting standards; b. Summarize loans that do not comply with standards through either approved exceptions or loan deterioration; c. Summarize loan pricing in correlation to compliance with loan underwriting standards; and d. Provide sufficient information to monitor the performance of the loan portfolio and

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determine compliance with lending policies, including underwriting standards and credit administration criteria. e. Provide sufficient summary information on loan underwriting standards compliance, the portfolio's historical performance, and existing risk exposure to effectively integrate credit standards with the allowance for loan loss analysis and planning for capital needs.

2. Determine if the IS effectively links borrower financial and credit information to the loan accounting system to provide a comprehensive database for loan portfolio management. Determine if sufficient IS controls are in place to ensure that borrower financial and credit data is accurate and current. Determine controls ensure that loan underwriting ratios are calculated in accordance with policy and procedure and are they consistent over reporting periods.

3. Review lending authorities delegated to management, lending staff, and the loan committee for appropriateness and reasonableness.

4. Review a sample of loan actions to determine if management, lending staff, and the loan committee acted within the lending authorities established.

5. Review management and lending staff performance plans and standards to determine if they are consistent with the authorities granted and the lending objectives of the institution.

6. Review performance evaluations to determine if management and lending staff are held accountable for complying with the standards established.

7. Determine if the loan committee is used to effectively control risk by examining a sample of loan actions approved by the committee and noting whether lending policies, procedures, and underwriting standards are adhered to and enforced.

8. Based on the procedures completed above and the examination of loans to test and verify the implementation and effectiveness of the systems, processes, and controls listed, conclude on the adequacy of loan portfolio management.

9. Discuss tentative conclusions and examination findings with examiners assigned areas that may be affected by the findings.

10. Discuss items of concern, scope of work performed, and conclusions with the EIC and with the appropriate institution manager. Obtain a response regarding the cause(s) of deficiencies or weaknesses and anticipated corrective actions.

11. Prepare a leadsheet or other summary document to provide workpaper support for the work performed and the conclusions reached.

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Scorecard Lending

Scorecard lending is a loan underwriting tool that attempts to statistically quantify a borrower's probability of repayment. This probability is based upon a number of factors statistically substantiated to be predictors of a borrower's willingness and ability to repay his debt. Scorecards vary by institution and by district, but in almost every scorecard developed, credit bureau information is a key component. As with conventional underwriting methods, a borrower's repayment history is an important consideration in determining a borrower's willingness to repay future debt obligations. The assignment of a score to this and other credit factors results in an overall credit score that determines the probable creditworthiness of the borrower.

Factors comprising the scorecard vary by underwriter, as does the level of inherent risk. For example, a term loan scorecard might consider such factors as the percentage financed, time at present address, repayment history with FCS, number of years in farming, as well as credit bureau information. An operating scorecard might also consider time at present address, repayment history with the Farm Credit System (FCS), number of years in farming, and credit bureau information. However, instead of considering percentage financed, the operating scorecard might consider ownership equity and net income.

The factors used in developing the scorecard have been determined to be most predictive in separating good and bad repayment prospects. The term "goods" and "bads" are often used in credit scoring circles to distinguish credit prospects. Definitions for "goods" and "bads" vary by user, but generally "goods" are defined as those accounts you would like to have in your portfolio, whereas "bads" are accounts you would decline if you knew how they would perform, i.e., excessive delinquencies, high servicing costs, credit losses, etc.

The acceptance score determined by the underwriter impacts the ratio of "goods" to "bads". Also known as the "cutoff" score, this score is key to determining the level of risk the underwriter is willing to assume. The higher the required score, the lower the underwriting risk and vice versa. Establishment of a cutoff score that is reflective of the risk bearing ability of the institution is one of many keys to successful use of this tool.

Examination Objectives:

The fundamental examination objective in the scorecard lending area is to determine if risk in the scorecard portfolio is appropriately managed and is within the association's risk-bearing ability. This is accomplished through the following principal objectives:

Assess the statistical validity of the credit scoring model either through the outside vendor or through monitoring actual credit history of borrowers in relation to the model.

Assess the risk associated with override decisions. Assess the adequacy of risk controls over the credit scoring process. Evaluate management of the scored portfolio.

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Examination Considerations and Guidance:

The primary factor that increases risk to institutions using scorecard lending is the failure to thoroughly analyze the borrower's financial condition and repayment capacity and obtain a complete balance sheet and income statement at the time a scorecard loan is made. The absence of this information makes it impossible to fully analyze the borrower's financial condition and credit worthiness and, ultimately, the risk to the institution. Examiners must be cognizant that even if complete financial information is obtained, it may not be used in the scorecard process.

The various areas that must be considered when evaluating scorecard lending programs and the risks associated with each area are discussed below. These include scorecard validation, override decisions, risk controls, portfolio management, and reporting. In evaluating scorecard lending programs, consideration must be given to the overall condition of the institution, the levels of activity and volume in the institution's scorecard portfolio, and the capacity of the institution to handle the risk permitted by the board's policy on scorecard lending.

Scorecard Validation:

Achievement of statistical validation is a key objective of the credit scoring process. The primary objective of the validation process is to determine whether the scorecard effectively "rank-orders" risk. Rank ordering of risk is simply the process of proving statistically that loans with higher credit scores result in fewer delinquencies than those with lower scores. The process of validation will require an analysis of loan performance by each of several 10-point scoring bands. For example, loans scoring 190-199 will be compared against those scoring 200-209. Theoretically, delinquencies will be greater with the lower scoring loans than the higher scoring loans. If this can be proven statistically across a broad range of scoring bands, the scorecard will have passed the first step toward achieving statistical validation.

Once this process is complete, the underwriter should be in position to predict an expected loss rate by scoring band. Odds tables for each scoring band should be developed and used to predict future losses. Such information is useful in a number of ways. First, it assists management in establishing a risk tolerance level. This is especially useful when establishing the appropriate cutoff score for that institution. Second, such information is instrumental in risk-based pricing. Lastly, establishing loss rates is critical to the analysis of allowance for loan loss adequacy.

From an examination standpoint, examiners must determine whether the association's scorecard has been statistically validated to rank-order risk and whether odds tables have been established. Examiners also need to be cognizant of whether the odds tables were established during favorable economic conditions. If the odds tables were established only during favorable economic conditions, loss rates during an economic downturn would be higher than what the tables indicate. Until the scorecard has been validated and

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odds tables established, management must exercise caution and ensure the level of activity permitted in the program does not exceed the association's risk-bearing ability.

Overrides:

Overrides are loan decisions made outside the confines of the scoring model. Such decisions consist of both high and low side overrides. Low side overrides are typically the most common, and result in making the loan despite the failure of the borrower to achieve the minimum cutoff score. High side overrides are loans that are denied despite the borrower achieving a score at or higher than the established cutoff score.

Override decisions are usually confined to three basic types: policy, informational, and intuitive. Probably the most common of these is the policy override, whereby management established special rules for certain types of applicants. For example, the policy override is common for current FCS customers in good standing with the institution despite the fact that the borrower may not score above the cutoff. Informational overrides are those made because the credit analyst has information on the applicant that is not part of the scoring model. For example, an analyst may override the approval of an applicant who achieved the cutoff score but recently filed for bankruptcy. The third and most dangerous override decision is the intuitive override. This is an override based on judgment or "gut feeling."

An association's override strategy should include the following:

The objective of the override strategy must be made explicit. A list of specific override reasons should be identified. The reasons must be

rational, rather than intuitive, and based on reasoning that can be stated and validated.

The strategy must be able to be implemented consistently by lending officials. All overrides should be tracked, and their performance by individual group should

be evaluated. The minimum information needed is score and override code. The name of the credit analyst making the override decision should also be recorded if the institution is tracking analysts' performance.

In addition to the above, institutions must set an override rate. Override frequency should be limited. When management sets the override rate, consideration should be given to the types of overrides. For example, overrides to existing customers may be less risky than those to new customers for whom no financial information is obtained other than that gathered as part of the scoring process. The entire override process must be viewed within the framework of the institution's risk-bearing capacity.

Risk Controls:

The adequacy of risk controls is a key management component of the scorecard portfolio. These risk controls can be many, but the four critical ones are outlined below. They

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include the adequacy of policies and procedures, risk parameters, allowance for loan losses, and loan pricing.

Policies and Procedures -- The critical component to the success of risk control is the institution's policies and procedures. The policy should clearly prescribe the extent of exposure the board is willing to commit to scorecard lending (e.g., as a percentage of total capital). As discussed earlier, another key aspect that should be included in any such policy is the issue of overrides. Once the comfort level on the cutoff score is set, the override policy becomes the key aspect of risk control in this program. For this reason, examiners must make evaluation of policies and procedures on the override process a top priority.

A number of other areas warrant inclusion into a scorecard policy. Many of these are the same types of controls common to managing the non-scorecard portion of the portfolio. These include limits to individual customers (to limit risk by size or to control multiple transactions to a single customer), types of eligible loans (by size or other criteria), required reporting, lending authorities, etc.

Risk Parameters -- The board needs to set parameters for the scorecard portfolio that are commensurate with the association's risk-bearing ability. Some of the factors that need to be considered when setting these parameters include scorecard validation, number of part-time farmers using the scorecard, cutoff score, override rates, and collateral requirements. It is conceivable that the association might establish more than one parameter. For example, the board might set a parameter for the scorecard loans that are secured and set another parameter for those that are unsecured. The parameters should not result in excessive risk. The percentage of scorecard loans in relation to total capital is a critical measure of the safety and soundness of the program and the extent to which the board is willing to expose shareholder equity to the risk in scorecard lending programs.

Allowance for Loan Losses (ALL) -- The ALL is the primary method for quantifying risk in the scorecard portfolio. The odds tables and loss rates make it simple to establish the appropriate ALL to accommodate the unique risks in this portfolio segment.

Loan Pricing -- The scorecard portfolio probably lends itself to more accurate loan pricing than any other portfolio segment, assuming the appropriate odds tables and loss rates have been developed, as previously discussed. Since these factors are usually determined by scoring band, loss rates should be objectively derived by risk level and incorporated into the pricing policy.

Portfolio Management:

Portfolio management of scorecard lending can be a challenge because financial information is not always obtained as part of the scoring process. Complete balance sheet and income statement information is usually not obtained at the time most scorecard loans are made. Nevertheless, a scorecard program must be managed on an ongoing basis

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just as any other loan program is managed.

Some institutions have begun the process of assigning a risk rating to the scorecard portfolio on a loan by loan basis. The risk rating is based on the loan type and the credit score. Risk rating the scorecard portfolio allows association management to perform sensitivity analysis and migration analysis on that segment of the portfolio. This type of analysis is critical to adequately manage the portfolio on a macro basis.

Economic assumptions impacting credit quality are just as applicable to the scorecard portfolio as the traditional portfolio. However, there are some potentially unique characteristics of the scorecard portfolio that may impact the types of economic data considered. In many cases, the scored portfolio has a much higher likelihood of being "agriconsumer" than the traditional portfolio. These borrowers are generally much more likely to be dependent on off-farm income to make payments. Therefore, investigating the need for broadening the base of economic assumptions may be warranted for the scorecard portfolio. Management should consider such things as the adequacy of the cutoff score and the override policy when economic conditions change. In the case of a downturn in the economy, it may be prudent to consider raising the cutoff score. In addition, management may institute new restrictions on overrides to better control risk if defaults occur.

Reporting:

The types and quality of reports used by management to monitor the scorecard portfolio must be evaluated. Loans made under scorecard programs are typically very dependent on delinquency information, which drives risk and accounting classification changes. Therefore, delinquency reporting is a key consideration. Reports monitoring overrides, including those to new versus existing customers, are also important. At a minimum, reports must inform the board of management’s compliance with procedures and board-established parameters.

Examination Procedures:

The following provides model examination procedures for conducting an evaluation of an institution's scorecard lending program. Consistent with risk-based examination practices, examiners should add, delete, or modify procedures as needed based on the particular circumstances of the institution.

1. Determine whether the scorecard has been statistically validated to rank-order risk and determine the extent to which this has been accomplished by scoring band.

2. Determine whether odds tables and/or loss rates have been formulated and the extent to which they will be re-evaluated over time given differing business cycles.

3. Evaluate the institution's override policy to ensure it includes, at a minimum, the following:

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The objective of the override policy, A reasonable override rate that considers characteristics of the scorecard portfolio, A list of acceptable specific reasons for overriding, Actions to ensure consistency of application of override rules among credit

analysts, and Monitoring and reporting requirements.

4. Perform an analysis of the volume and type of overrides to ensure they are commensurate with the association's risk-bearing ability.

5. Select a sample of overrides and determine whether the reasons for overrides are objective and comply with institution policy.

6. Determine whether the cutoff score is reasonable and based on the risk-bearing ability of the institution.

7. Evaluate the thoroughness of the scorecard lending policy to ensure it includes program objectives and appropriate risk parameters, types of loans eligible, reporting considerations, lending authorities, etc.

8. Query and analyze the scorecard portfolio database to evaluate compliance with lending limits to individual borrowers, restrictions on transactions to single customers, etc.

9. Evaluate the policy for risk/accounting classifications and charge-offs for reasonableness.

10. Assess whether the institution has analyzed and determined the causes of losses on its scorecard lending program.

11. Evaluate the ALL policy to determine the use of loss rates and probability tables and the extent to which the ALL level for scorecard lending programs is adequate.

12. Assess the loan pricing policy to determine whether the portfolio is differentially priced based on risk and whether odds tables and loss rates are used in the pricing model.

13. Determine what techniques the institution uses to assess portfolio risk on a macro basis.

14. Determine the extent to which economic data is utilized to assess risk in the portfolio, alter the cutoff score, and/or change override policies.

15. Determine the types of reporting used to monitor the scorecard portfolio and whether they are sufficient to identify risk.

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Asset Quality

Assets can expose the institution to substantial risk. In addition, the quality of assets can significantly affect profitability. This makes quality an important factor in determining the overall adequacy of assets.

The inherent risks in lending makes the quality of loans and the loan portfolio significant factors in assessing overall asset quality. There are numerous quantitative measures which are useful in analyzing risk in the loan portfolio. Common measures include:

Delinquent loans; Nonaccrual loans; Restructured loans; Impaired loans; Adverse assets; Criticized assets; Principal and/or interest federally guaranteed; and Allowances, chargeoffs, and recoveries.

Examiners should consider the trends in these amounts and their relationship to total loans. Significant adverse trends should be examined to identify why the situation exists.

It is also important to look at the loan portfolio from other perspectives besides just aggregate volumes and percentages. For instance, consider the following questions in analyzing the makeup of adverse loan volume:

Is there a common basis of criticism? Are they mostly current or delinquent? Are many of the loans nonaccrual or impaired? Are they typically well secured or under-secured? To what extent are they guaranteed? Are many of the loans restructured? When do most of these loans mature? Are the adverse loans today the same loans that were adverse last year? Are the loans concentrated in certain commodities or dependent on similar

sources of repayment?

Asset Classifications

Farm Credit System (System) institutions use asset quality classifications to identify and disclose risk in the loan portfolio. The classification system predominantly used by System institutions is the Uniform Classification System (UCS). UCS classifications express the degree of risk of nonpayment in individual assets. As discussed in the Loan Portfolio Management section of this module, effective risk identification is essential to the safe and sound operation of System institutions.

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This section provides examiners with guidance for classifying loans and loan-related assets for the purpose of verifying the effectiveness of management's risk identification process. The section includes a description of the UCS, the credit factors analyzed to assign a UCS classification, and a listing of procedures that can be used to examine this area.

Examination Objective:

Determine if management is adequately identifying risk in the loan portfolio through the UCS or an alternative system of risk measurement.

UCS Classifications and Standards:

Two elements are necessary to develop classification results into meaningful data: clear, well-understood classification definitions, and uniform application of the definitions. The UCS provides the classification definitions necessary to develop meaningful data on the quality of the loan portfolio.

While the UCS is primarily used to evaluate the quality of the loan portfolio, it can also be used to assess risk in other property owned and the investment portfolio. Other property owned is considered a Substandard asset, although generally not assigned a specific credit classification. In some instances, however, it may be appropriate to classify a portion of such property Doubtful or Loss to reflect a high possibility of loss or a known loss, respectively. In contrast, investments held by System institutions are typically of high quality, are readily marketable, and would normally be classified Acceptable. Nevertheless, if concerns exist as to the ultimate collectibility of an investment, such as Federal Funds sold to a troubled financial institution, it may be appropriate to criticize the investment. The examination of investments is further discussed in the Investments section of this module.

UCS credit classifications are assigned on the basis of risk and include the following five categories: Acceptable, Other Assets Especially Mentioned, Substandard, Doubtful, and Loss. Assets classified Substandard, Doubtful, and Loss are considered adversely classified assets; assets classified less than fully Acceptable (i.e., Other Assets Especially Mentioned, Substandard, Doubtful, and Loss) are considered criticized assets. Assets may also be assigned more than one classification when portions of the asset clearly meet different classification standards. A general description and application of each classification category is provided below.

1. Acceptable

These are noncriticized assets of the highest quality. They do not fit into any of the other categories. This category is also used to classify the guaranteed portion of government-guaranteed loans. Upon determination that the loan guarantee constitutes an enforceable contract, the guaranteed portion is classified Acceptable. The amount considered covered

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by the guarantee, for classification purposes, is the total outstanding balance (principal and interest) of the loan multiplied by the guarantee percentage. Criticism or adverse classification of guaranteed portions of loans may occur when enforceability of the guarantee contract is jeopardized. The remaining balance, or nonguaranteed portion, should be classified according to the standard classification criteria.

2. Other Assets Especially Mentioned (Special Mention)

Assets in this category are currently protected but are potentially weak. These assets constitute an undue and unwarranted credit risk, but not to the point of justifying a classification of Substandard. The credit risk may be relatively minor yet constitute an unwarranted risk in light of the circumstances surrounding a specific asset.

Special Mention assets have potential weaknesses that may, if not checked or corrected, weaken the asset or inadequately protect the institution's position at some future date. Assets in this category may include loans that have deviations from prudent lending practices, and/or those subject to economic or market conditions that may, in the future, affect the borrower. An adverse trend in the borrower's operations or an imbalanced position in the balance sheet that has not reached a point where repayment is jeopardized may best be handled by this classification. This category should not be used to list loans that bear risks usually associated with the particular type of financing.

Any type of loan, regardless of collateral, financial stability, and responsibility of the borrower, involves certain risks. A loan secured by accounts receivable has a certain risk, but to criticize such a loan it must be evident that risk is increasing beyond the level at which the loan originally would have been granted. A rapid increase in receivables without the lender knowing the cause, concentrations that lack proper credit support, lack of on-site appraisals or inspections, or other similar matters could lead the examiner to question the quality of the receivables and possibly classify the loan as Special Mention. Loans in which actual, rather than potential weaknesses are evident and significant should be considered for more severe classification.

3. Substandard

These assets are inadequately protected by the repayment capacity, equity, and/or collateral pledged. Assets so classified must have a well-defined weakness or weaknesses that could hinder normal collection of the debt. They are characterized by the distinct possibility that the lender will sustain some loss if the deficiencies are not corrected. Loss potential, while existing in the aggregate amount of Substandard assets, does not have to exist in individual assets.

4. Doubtful

Assets classified Doubtful have all the weaknesses inherent in those classified Substandard with the added characteristic that weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable

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and improbable. The possibility of loss is extremely high. Because of certain important, specific, pending factors that may work to the advantage or disadvantage of the assets, classification as Substandard or Loss is deferred until a more exact status can be determined. Pending factors might include a proposed merger, acquisition, liquidation, capital injection, perfecting liens on additional collateral, or refinancing plans.

Examiners should avoid classifying an entire credit Doubtful when collection of a specific portion appears highly probable. An example of proper utilization of the Doubtful category is the case of an entity being liquidated, where the trustee-in-bankruptcy has indicated a minimum disbursement of 40 percent and a maximum of 65 percent to unsecured creditors, including the System lender. By definition, the only portion of the credit that is Doubtful is the 25-percent difference between 40 and 65 percent. A proper classification of such a credit would show 40 percent Substandard, 25 percent Doubtful, and 35 percent Loss.

5. Loss

Assets classified Loss are considered uncollectible and of such little value that their continuance as bookable assets is not warranted. This classification does not mean the asset has absolutely no recovery or salvage value, but rather it is not practical or desirable to defer writing off this basically worthless asset even though partial recovery may be effected in the future.

Delaying the recognition of losses due to the remote possibility that a restructure will occur is not considered consistent with the definitions contained in the UCS or generally accepted accounting principles. It is expected that an institution and the borrower will arrive at a formal agreement within a reasonable period of time following the start of negotiations to restructure. Normally, formal written agreements for restructuring should result within 6 months of the start of negotiations. Negotiations continuing for a significantly longer period without a final written agreement between the institution and the borrower indicates that the possibility of restructuring is remote. In these situations, the under-secured portion of the loan would be considered a known loss and should be charged off.

In cases where the entire loan is considered a loss, the portion of the loan equivalent to the stock outstanding may be considered Acceptable. If the stock is not to be applied on the loan or impairment of the institution's capital is involved, the Regional Director should be contacted for guidance.

Credit Factors

Accurate credit classification requires an analysis of the asset relative to the five credit factors. The five credit factors, or the five C's of credit, which the examiner evaluates in classifying loans are: capacity, capital, collateral, character, and conditions. The relative weight assigned to each credit factor varies with the circumstances of the individual situation.

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The following provides a general description of each credit factor.

Capacity

Capacity refers to the borrower's ability to repay. The determination of repayment capacity requires an analysis of cash flow, sources of repayment, and earnings history. Cash flow projections should be realistic in relation to past performance and should identify the source(s) of repayment. The source of repayment should be assessed to ensure repayments are expected from normal operations or from other recurring and reliable sources. Earnings history should evidence that future income is sufficient to meet all obligations, including normal living expenses, with some left for capital replacement and contingencies. Points to consider include:

Historic earnings performance; Repayment history; Stable and reliable income; Sources of repayment; Projected earnings; and Cash flow projections.

Capital

Capital relates to the ability to meet obligations, continue business operations, and protect against undue risk. The applicant's total assets, working capital and liquidity, amount of equity, contingent liabilities, financial progress, and history of earnings to date are significant measures of a borrower's capital position. Points to consider include:

Asset/liability structure; Working capital and liquidity; Owner equity position; Financial trends; and Earned net worth as a percent of total net worth.

Collateral

Collateral is the security pledged on the loan. Where applicable, the collateral amount taken must comply with regulatory requirements--it should reasonably protect the lender, provide the necessary control of equity and repayment, and leave the borrower in a position to constructively manage the business. The type, quality, and location of collateral, as well as its ability to produce income, are relevant factors used to assess collateral adequacy. In addition, personal or entity liability in the form of guarantors or partial guarantors may provide added strength in extending credit. Sufficient analysis should be made of credit factors relevant to such guarantors or partial guarantors to ensure they can reasonably provide support for the loan. Points to consider include:

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Reasonable lender protection; Perfected security interest; Current and accurate evaluation reports; Availability of additional collateral; Collateral risk (potential to decline in value); and Income producing and debt servicing ability of the collateral relative to its current

market value.

Character

Character refers to the borrower's integrity and management ability. Responsible and cooperative management must be evident. This factor is of such significance that it can affect the weight placed on the other credit factors, particularly if the evaluation of character is negative. Analysis should include a careful evaluation of management of finance and operations. Points to consider include:

Realistic production and financial goals; Adequate financial records; Proven management experience; Borrower's marketing plan/approach; and Compliance with loan terms.

Conditions

Conditions include the amount of loan, use of proceeds, and loan terms over which the lender has direct control. The conditions of a loan should be constructive in amount and purpose and practical as to repayment terms for both the borrower and lender. Conditions such as loan agreements, personal liability, additional collateral, and insurance should be required as each situation warrants. Points to consider include:

Prudent and productive loan purposes; Past experience in fulfilling conditions; Loan maturities coinciding with the purpose of the loan; Proper structure of loans financing specific major capital items; and Appropriate repayment plans/schedules established consistent with the source of

repayment.

Allowance for Loan Losses

The allowance for loan losses should be maintained at a level that is adequate to absorb the estimated amount of probable losses in the institution's loan portfolio. Therefore, it is a major factor in the evaluation of each institution's ability to absorb credit losses and the

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fairness and accuracy of its financial statements. The allowance for loan losses is a valuation account. The account is used as an offset to, or reduction in, the gross value of loans on the institution's balance sheet. The allowance for loan losses account is generally the largest allowance account. The principles for an other property owned allowance, or other valuation allowances, are similar.

FCA requires all Farm Credit System (System) institutions to maintain their allowances in accordance with generally accepted accounting principles (GAAP). The primary authoritative pronouncements under GAAP that address the establishment and maintenance of the allowance for loan losses are Statement of Financial Accounting Standards No. 5, "Accounting for Contingencies" (SFAS 5); SFAS No. 114, "Accounting by Creditors for Impairment of a Loan" (SFAS 114); and SFAS No. 118, "Accounting by Creditors for Impairment of a Loan--Income Recognition and Disclosure" (SFAS 118) which amends several provisions of SFAS 114.

This section provides criteria for evaluating the allowance for loan losses methodology used by System institutions. It also provides examination objectives and procedures that can be used in conducting an examination of this area.

Examination Objectives:

Determine if the institution's allowance for loan losses methodology is logical, appropriate, consistently applied and, to the extent applicable, conforms with specific GAAP requirements.

Determine the reasonableness of the institution's recorded allowance.

Evaluation Criteria:

For purposes of evaluating the adequacy of the allowance, management should consider all outstanding loan assets (including principal and interest), binding commitments to lend, and other off-balance sheet commitments such as standby letters of credit. In general, management of the institution should evaluate the adequacy of the allowance at least quarterly and make any necessary adjustments to the financial statements.

The management of each institution should establish an allowance policy requiring that a systematic methodology be used in estimating the allowance. The methodology established by the allowance policy must be logical, appropriate given the institution's particular circumstances, and consistently applied. In addition, the policy should require that the specific rationale and criteria used each period be documented for the purposes of verifying the reasonableness of the evaluation process and the adequacy of the amount. The policy also should specify the frequency of evaluations and guidelines for recognizing chargeoffs and recoveries.

At a minimum, the institution must document the basis for the allowance including estimates made on individually identified impaired loans and assumptions used, and

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estimates made on pools of loans. If the institution makes a large or unusual provision (addition or reduction) to the allowance in the current period, documented evidence must clearly establish that the provision should have been in the current period rather than in any prior periods.

When analyzing the adequacy of the allowance, all loans should be evaluated either individually or as part of a pool of loans. Institutions should, however, segment their loan and lease portfolios into as many homogeneous components as practical. Each component would normally have similar characteristics, such as risk classification, past due status, and type of loan, industry, or collateral. For example, an institution might segment its portfolio into the following components for analysis:

Significant credits that are specifically analyzed, including, at a minimum, all large adversely classified credits;

Other problem credits, if not included in the population of loans specifically analyzed (i.e., analyzed on a pool basis); or

All other loans that have not been considered or provided for elsewhere, standby letters of credit, and other off-balance sheet commitments to lend.

The institution should combine its estimates of the allowance needed for each component of the portfolio, including loans analyzed individually and loans analyzed on a pool basis, to arrive at the total allowance necessary to absorb probable losses in the institution's loan portfolio. Even though the process for determining the adequacy of the allowance is based upon the analysis of segments of the portfolio (i.e., individual loans and pools of similar loans), this does not mean that any part of the allowance is segregated for, or allocated to, any particular asset or group of assets. The allowance is available to absorb all credit losses inherent in the portfolio.

Providing for Estimated Losses on Individually Identified Impaired Loans

Identifying Impaired Loans-- SFAS 114 provides guidance as to when and how financial institutions should establish allowances for loan losses on specifically identified impaired loans. Under the provisions of SFAS 114, a loan is considered to be impaired when, "...based on current information and events, it is probable that a creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement." This statement does not, however, provide guidance on determining when it is probable that the creditor should apply its normal loan review procedures in making such a determination. To a large extent, the factors involved in determining whether a loan is impaired are the same as for determining whether a loan should be categorized as a "high-risk" loan or whether the loan should be assigned an adverse loan classification. These factors include: the borrower's character; overall financial condition; financial resources; payment record; the prospects for support from financially responsible guarantors; and, if appropriate given the institution's current plans for collection, the value of any collateral. Accordingly, an institution's loan review procedures used to establish performance and credit classifications will be useful in identifying which loans

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are probably impaired and need to be specifically evaluated for impairment.

The classification of a credit reflects a judgment regarding the risks of default and loss on the loan. It follows then that an adversely classified credit reflects a judgment that these risks are greater than normal. A loan, or a portion of a loan, classified Loss is considered uncollectible and, as such, is an unbankable asset. In general, the institution should have already determined the appropriate allowance needed to cover the estimated and yet unconfirmed loss before the loan is classified Loss. Accordingly, loans classified Loss should be charged off against this existing allowance at the time the loss becomes known. With respect to a loan classified Doubtful, weaknesses are present that make full collection of the loan highly questionable and improbable. While a Doubtful loan will not have a known loss that requires a chargeoff, it is by definition considered impaired and will likely have significant potential loss that must be provided for in the allowance. The institution should specifically evaluate all significant credits classified Doubtful in order to estimate the potential loss associated with each credit. The balance of Doubtful loans should be evaluated individually or on a pool basis. The risk of default on individual loans classified Substandard is less than for loans classified Doubtful. Nonetheless, experience has shown that there is impairment associated with some Substandard loans. Larger Substandard credits should probably be analyzed on a loan-by-loan basis. However, analyzing and providing for estimated losses in Substandard loans as part of a pool of similar loans would not be inappropriate.

With regard to performance classifications, by definition nonaccrual loans and most troubled-debt restructurings will be considered impaired and should be specifically evaluated to determine the level of impairment. Also, because the recognition of impairment is dependent on the timing of collection in accordance with the contractual terms of the loan as well as the determination of the loan's ultimate collectibility, it is likely that most severely delinquent loans will be considered impaired even though collection in full may be reasonably expected. Accordingly, significant delinquent loans should also be specifically evaluated to determine the level of impairment.

In addition to those loans evaluated for impairment because of assigned credit classifications, other loans may warrant analysis by the institution. For example, the institution may want to perform an analysis of loans over a certain dollar limit. Even though the loan may not currently be a classified credit, the loan's sheer dollar volume may pose additional risk to the institution should the credit quality begin to deteriorate. It may be appropriate, therefore, for such loans to receive closer scrutiny by the institution.

Measurement of Impaired Loans--If a loan is determined to be impaired, the measurement of the impairment is generally based on the present value of expected future cash flows discounted at the loan's effective interest rate. If the present value is less than the recorded investment, the impairment is recognized by establishing an allowance for loss on the impaired loan with a corresponding charge to the provision for loss (expense) account. Subsequent changes in the measure of impairment should be effected through adjustments to the provision for loan losses.

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Estimating the present value of cash flows on a problem loan will oftentimes not be an easy task. Because of the inherent difficulties in estimating the present value of expected future cash flows, SFAS 114 allows, "as a practical expedient," impairment to be measured based on the loan's observable market price, or the fair value of the collateral if the loan is collateral dependent. Generally, a measurement method will be selected on a loan-by-loan basis. However, when the creditor determines that foreclosure is probable, measurement must be based on the fair value of the collateral. Measurement of impairment based on the loan's observable market price is not a practical option for most System institutions. As indicated above, these measurement methods will most often be applied on a loan-by-loan basis. However, SFAS 114 also recognizes that some impaired loans may have risk characteristics in common with other impaired loans. For this reason, the institution may aggregate those loans and may use historical statistics such as average recovery period and average amount recovered, along with a composite effective interest rate as a means of measuring impairment of those loans.

Providing for Estimated Losses in Pools of Loans

The institution must analyze its entire loan portfolio in order to determine an appropriate level for the allowance. Generally, however, it is not practical or necessary for institutions to analyze and provide allowances for all loans individually. As discussed previously, institutions should analyze all significant credits and perform an analysis of classified loans either on an individual basis or collectively. The determination of the allowance for the balance of the portfolio, usually representing the majority of loans, is a difficult process and requires management to make a significant number of estimates and assumptions. Institutions may provide for such credits as part of a pool of loans based on historical loss experience, adjusted for changes in trends and conditions, as well as consideration of other pertinent factors.

FCA does not require the use of a particular methodology to evaluate the adequacy of the allowance on individual loans or by pools of loans. However, regardless of the methodology used, it is important that it reflect only probable losses (i.e., unconfirmed losses that probably exist and can be reasonably estimated as of the evaluation date) rather than the risk of loss in the future. One methodology that is commonly used involves determining the adequacy of the allowance on pools of loans based on historical experience. While this is a practical methodology, the analysis should adjust the historical loss factors to reflect any current conditions that are expected to affect loss recognition. Factors for the institution to consider should include, but are not limited to:

Levels of, and trends in, delinquencies and nonaccruals; Adequacy of risk identification systems including the internal credit review and

internal audit processes; Trends in volume and terms of loans; Adequacy of, and adherence to, lending policies and procedures including those for

underwriting, collection, chargeoff, and recovery; Experience, ability, and depth of lending management and staff; National and local economic trends and conditions which affect the loan portfolio; Exposure to collateral risk;

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Concentrations of credit that might affect loss experience across one or more components of the portfolio; and

Environmental risk.

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EXAMPLE RATINGS TRANSMITTAL LETTER

Date

Mr. ________________________ , ChairmanBoard of Directors(Institution)__ __ Street AddressCity, State ZIP

Mr. _______________________ , Chief Executive Officer(Institution)__ Street AddressCity, State ZIP

Dear Mr./Ms. _(Chairman's name)_ and Mr./Ms. _(CEO's name)__:

This letter contains the Farm Credit Administration's (FCA) composite and component CAMEL ratings for the ___________________ Association/Bank based on the Report of Examination as of (date) . These ratings are strictly for the confidential use of the board of directors and the chief executive officer. Under no circumstances shall any person associated with the institution make public the composite or individual component ratings.

The purpose of the FCA Rating System is to provide a uniform evaluation of the main characteristics of all Farm Credit System institutions and ensure a consistent examination and regulatory approach to institutions with similar risk. The FCA's composite rating definitions, factors considered in assigning component ratings, and other information pertaining to the FCA Rating System may be found in the FCA Examination Manual.

The _______________________ Association's/Bank's composite rating is " ." The individual CAMEL component ratings are:

____ Capital ____ Assets ____ Management ____ Earnings ____ Liquidity ____ Sensitivity

While these ratings provide some insight as to the overall condition of your institution, we urge the board of directors to address the conditions identified in the Report of Examination rather than focus on the ratings.

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Representatives from our office will be available during the __(date)___ board meeting to discuss your institution's condition and the Report of Examination. We will discuss any questions you may have regarding the above ratings at that meeting. Should you have any questions regarding the contents of this letter or other matters pertinent to the examination prior to the scheduled meeting date, please contact me at __(phone number)_.

Sincerely,

__________________ , Director__________________ Field OfficeOffice of Examination

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